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Adoption of Full Capital Account Convertibility

July 23, 2014

In the previous articles we have understood what Full Capital Account Convertibility is and delved into few of the factors that determine Full Capital Account Convertibility (FCAC) approach is feasible or not. We will try to understand the effect of FCAC using the South East Asian crisis and its adoption.

FCAC and South-East Asian Crisis

The Asian Crisis of 1997-98 originated from Thailand. The Baht (Thai currency) was at that time pegged with US Dollar. As dollar appreciated, so did Baht, exports decreased, export competitiveness also reduced, leading to increased current account deficit and trade deficit. Thailand was heavily reliant on foreign debt with its huge CAD being dependent on foreign investment to stay afloat. Thus there was an increased forex risk.

As US increased its domestic interest rate, the investors started investing more in the US. It led to capital flight. Forex reserves rapidly depleted, and the Thai economy tumble down. Thai government decided to dissociate Baht from the US currency and floated Baht. Concurrently, the export growth in Thailand slowed down visibly.

Combination of these factors led to heavy demand for the foreign currency, causing a downward pressure on Baht. Asset prices also decreased. As asset prices fell, there was heavy default on debt obligations. Credit withdrawal started.

This crisis spread to other countries as a contagion effect. The exchange markets were flooded with the crisis currencies as there were few takers. It created a depreciative pressure on the exchange rate. To prevent currency depreciation, the governments were forced to hike interest rates and intervene in forex markets, buying the domestic currencies with their forex reserves. However, an artificially high interest rate adversely affected domestic investment, which spread to GDP, which declined, and eventually economies crashed.

In this backdrop, the most vicious argument offered by the opponents of FCAC had been the role of free currency convertibility. In the absence of any capital control, no restrictions were kept on capital outflow, and thus the herd behavior of investor led to economic crash of the entire region.

Adoption of Full Capital Account Convertibility

The following observations and lessons can be summarized:
  • Most currency crises arise out of prolonged overvalued X-rate regime. If the X-rate appreciates too high, the economy’s export sector becomes unviable by losing export-competitiveness at a global level. Simultaneously, imports become more competitive, thus CAD increases and becomes unsustainable after a certain limit.
  • Large and unsustainable levels of external and domestic debt had added to the crises, too.
  • Domestic financial institutions need to be strong and resilient to absorb and minimize the shocks so that the internal ripple effect is least.
  • Gradual CAC is the safest way to adopt. However, even a gradual CAC cannot fully eliminate the risk of crisis or pressure on forex market.


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